Minimum wages: The economist as a psychologist

Both Ludwig von Mises and F.A. Hayek are known for arguing that there is no such thing as a good economist who is only an economist. For these two thinkers, a good economist-as-scientist also needs to know history, philosophy of science, ethics, and physics. Mises and Hayek are thinking of what an economist-as-scientist should be familiar with and have some minimum knowledge beyond his discipline.

I would add that the economist as public educator, that is, when the economist talks as an economist to non-economists, also needs some awareness of psychology. I may not be using the term “psychology” in the most proper way, but I mean the awareness to understand what the interlocutor feels and needs and then figure out how to communicate economic insights in a way that will not be automatically (emotionally or psychologically) rejected; how to make someone accept an economics outcome they do not want to be true. How to break the bad news with empathy? This is a challenge I try to get my students to understand as one day they, too, will be economists out of the classroom in the real world.

A few days ago I found myself unexpectedly in the “psychologist” position. Only seconds after meeting for the first time two persons dropped the question: “So, what do you think about increasing the minimum wages, should we do it?” I knew nothing about these two individuals, and the only thing they knew about me was that I’m an economics professor. The answer to such a question is an Econ 101 problem: if you increase the minimum wage (above the equilibrium price) some lucky workers will get a wage increase at the expense of other ones loosing their jobs.

The first question I asked myself was “what do these two nice ladies actually want, the analytical/scientific answer, or do they want instead the ‘professor’ to confirm their bias?” This might be a delicate discussion since they may well have a loved one in the minimum wage market.

The first thing to get out of the way is that my answer as an economist is not ideologically driven or does not respond to secret political agendas. How can that be made clear? One way is to show the economics profession’s consensus on the subject from an impersonal position. I explained to them that any economics textbook from any author from any country in the world used in any university would say the same thing: “If you put the price of labor above its equilibrium (a minimum wage), it will produce a disequilibrium (unemployment). You cannot fix the price outside equilibrium and at the same time remain in equilibrium.” Yes, as Ben Powell reminds us, even Paul Krugman agrees on this. By mentioning a worldwide consensus there is no room for ideological or political agendas. It is important to mention that economics is not always about politics. The economic analysis of minimum wages has nothing to do with being a Democrat or a Republican; the political position of each party may differ, but those are not economic analyses, those are political strategies.

The next step was to deal with the issue that if such a consensus exists, why are there mentions of studies showing no harmful effects of increases in minimum wages. This is no mystery either. A well known reason of why an increase in minimum wages does not increase unemployment is because in fact there is no such increase. The politician may say he is increasing the minimum wage, but he does not say that the minimum wage is being located just above the equilibrium level and therefore he is not doing much. Another reason is to look at the effect of a minimum wage increase in a small location where low skilled workers can get another job in the next town without the need to move and therefore they will not show up as unemployed. This is another case of an ineffective increase in minimum wages. Or maybe the minimum wage increases but a benefit goes down. The total compensation to the employee does not change, its composition does.

But can the economist show his claim? Is there more clear evidence that the effects of increasing minimum wages does do harm than the complicated cases where there are no harmful effects? Again, I went geographically large. First, I compared the U.S. with Europe, which has higher minimum wages with respect to the U.S. In Europe you find higher unemployment rates, higher unemployment in the youth population, and also higher long-term unemployment. Second, I brought the case of the U.S. Fair Labor Standard Act of 1938, which fixed the minimum wage at 25 cents per hour. This law included Puerto Rico where the many workers were earning between 3 to 4 cents. Bankruptcies and unemployment skyrocketed. It was in fact unions who asked Congress to make an exception for Puerto Rico, which took two years to consider. For two years people in Puerto Rico were forced to work in the black market or fail to make a minimum income. Want more cases? See here. “See,” the psychologist says, “minimum wages are very dangerous; you can seriously harm yourself. Is that a bet you really want to make?”

Two issues remain to be explained after dealing with these three problems, (1) objection to minimum wage increases is not (necessary) an ideological or political position, (2) studies that deny the effect are doubtful for easy reasons to understand, and (3) if you look at a sample broad enough the economist’s prediction is right there.

First, when an economist objects to an increase in minimum wages it does not mean we do not want wages to go up. We are just saying that a minimum wage increase is not the right way to do it. I wish it were so easy, but the laws of demand and supply inform otherwise. I guess most economists would advocate for minimum wages if their negative effects were not real. Second, explain Milton Friedman’s lesson that a policy is valued by its results, not by its intentions. The economist objects because of the unintended effects of fixing the price of labor outside equilibrium, not because we wouldn’t like to see real wages increasing.

9 thoughts on “Minimum wages: The economist as a psychologist”

“For example, the Tax Policy Center estimated in November that Trump’s 15% proposal, coupled with a repeal of the corporate Alternative Minimum Tax, could reduce revenue by nearly $2.4 trillion in the first decade.”
“Treasury Secretary Steven Mnuchin has said, however, that Trump’s tax plan would be paid for through economic growth. Experts throw cold water on that idea, since there is no evidence that tax cuts pay for themselves.”

As an economist talking to a sociologist, what should I expect? Would a 15% tax rate pay for itself with economic growth?

First, there is a difference between the problem of taxes paying themselves and the topic of my post. What I tried to show, with the minimum wage example, is the difficulty of dealing with emotional subjects. This “emotional challenge” is not present in the problem of whether or not taxes pay themselves.

Whether or not taxes pay themselves does not have a definite answer. It depends on to effects that go on opposite directions. The reduction in taxes reduces the revenue. But the reduction in taxes also makes running business cheaper (and increases the disposable income of clients) and therefore business expand. This second effect makes the tax revenue increase. Whether or not taxes would pay themselves depends on which one of these two effects is larger. This trade-off is also known as the Laffer Curve.

I’m not familiar with estimations (if there’s any) about what the outcome would be for a 15% proposal.

So you also think that there will be no emotional challenge in the upcoming battles over taxes? I will admit to condescension and derision towards all dispensers of sparkly unicorn dust. You will note that I didn’t quibble a bit with the bulk of Prof. Cachanosky’s comment i.e. he doesn’t know. I have no problem with that, I don’t know either.

This relates to whether tax cuts pay for themselves. Using the latest CBO assumptions (1.9% RGDP growth; 2.0% real interest rate), any tax cut that produces a measurable increase in economic growth will pay for itself on a “present value” basis (which is the correct way to do the calculation)

For example, the increase in RGDP growth required to pay for eliminating the entire corporate income tax (which the CBO expects will bring in 1.6% of GDP) is only 0.02 percentage points (i.e., the RGDP growth rate would have to rise from 1.90% to 1.92%). This is less than the BEA can measure.

So, any supply-side tax cut will more than pay for itself. If you owned the federal government and got to keep all of the money that the tax system brings in, you would cut taxes (at least on savings and investment).